Friday, February 26, 2010

Since the devaluation crisis of 1967, the UK has followed a policy where problems that emerge in the economy are cushioned by devaluing the currency. The poor productivity of the British economy has thus been mitigated to a great extent. In fact, since 1992 when the Conservative government was forced to leave the exchange rate mechanism, which closely linked European currencies, Tories have tended to regard keeping the right to devalue as a key part of maintaining British competitiveness. They dress this up in the Union Jack: "Keep the Pound!", with the unspoken message that other currencies are a lesser store of value and somehow inferior. In fact despite the instability in the Euro over the past few weeks, Sterling has performed worse. British inflation is higher, and so are British interest rates. The fact is that British currency policy, as with so many other British industrial and economic policies over the past forty years, has been an exercise in taking the soft option.

The failure to take on the Kremlin funded trade unions of the 1970s. The failure to broaden our education system and promote the value of hard work, the failure to modernise our infrastructure rapidly enough, the failure of management, the failure of industry, all have been mitigated by allowing Sterling to fall at key moments. Yet there has been a major price for this. In order to maintain investment levels the British economy has had to operate under significant constraints. The UK was forced to keep government debt low, even while household debt - mostly to fund housing and consumption- exploded: the UK was not investing, it was spending.

Now, the collapse of the financial sector has severely damaged one of the primary earnings streams of the British economy. In order to fill the gap, the once relatively low levels of government debt have been nearly doubled over eighteen months. The government deficit- high even in the boom years- is now over 16% of GDP, and the highest in Europe. The UK monetary authority, the Bank of England, desperate to avoid deflation, has massively increased the monetary mass- yet the economy has seen no real GDP growth, and inflation, usually higher than our competitors, has begun to track upwards: the spectre of British "stagflation" is now a reality. Confidence is falling at a critical moment: people no longer talk about "V-" or "U-" shaped recovery, but "double dip" or even "L-" shaped, that is no recovery at all.

The British economy remains fundamentally unbalanced, with low interest rates not stimulating industrial investment, but simply continuing to fund grossly overvalued housing. It is quite clear that the unregulated estate agents are certainly not economists: how else could they speak of the housing market being "affordable" simply because short term interest rates are at historic lows. Just remembering that the average base rate since the Bank of England was founded in 1694 has been 5% should tell you that over the life of a 25 year mortgage it is that number -not the current 0.5% base rate- that is important. Using that as your discount rate will demonstrate at least a 20% overvalue in UK real estate prices.

Yet- the cautious bulls respond- that the damage that a rise in rates would cause, not least by increasing the cost of the dramatically increased government borrowing, means that rates will not rise. My response is that such a decision is not necessarily in the hands of the government or the Bank of England. The Government will need to sell a very large amount of government securities- "Gilts"- in order to fund this years deficit. Without an appropriate interest rate to compensate the risks that investors are taking on, there could indeed be the feared "Gilts strike", where investors refuse to fund the deficit. Although the Labour government may seem to think so, the fact is that the UK Treasury does not have a limitless pool of capital and the laws of demand and supply continue to operate in government securities as in any other market.

This brings us back to the Pound. The policy over the past two years has been to permit a devaluation greater than at practically any time in history and to print money through the quantitative easing programme. Despite all of this, and a drastic increase in the government deficit, the UK economy is still exceptionally weak. Our capacity to earn enough to repay the debts we are incurring is still falling. The result will be two-fold. Firstly interest rates will- inevitably- have to rise sharply over the course of 2010, which will negatively impact growth, making the problem worse. Secondly the value of Sterling will fall to reflect the higher risk and lower capacity of the economy. In addition there could be sharp speculative runs on Sterling, especially if the political outlook around the election continues to grow less clear.

The tertiary impact could then well be the correction in UK real estate market that everyone except UK estate agents forecasts. The impact of that will probably be that the UK banking system- particularly the building societies- will be weakened still further.

No one can be certain about the future, but even the prospect of this negative scenario will have a strongly negative impact on the Pound. In short the currency is in mid air- and the next few weeks could well see an old fashioned Sterling crisis. The long term policy of devaluation may be about to hit the buffers.

Then the really hard work of true structural reform and a fundamental realignment of the economy to make it sustainable for the long term must begin. It is going to be at least a decade of real slog.

Thursday, February 25, 2010

The possibility of the 2010 General election in Britain leading to a hung Parliament is now being seriously discussed across the news media. In fact it requites a very particular set of circumstances to lead to a hung Parliament, and usually minority votes still lead to a significant advantage for one party over another. Indeed the Labour Party was able to gain a majority government in 2005 with only just over 35% of the vote- barely a third of the votes. The electoral system does not reflect how people actually vote, and it has happened that the party that comes second in the national vote is still able to form a government.

Therefore no one can be confident about how the 2010 election actually turns out until the votes are counted and the election results declared. A very small number of votes in key "marginal" constituencies- probably less than 100,000- will ultimately decide who receives the mandate from the Queen to form a government.

Nevertheless despite the seemingly inevitable defeat for Gordon Brown's Labour Party, the Conservatives are clearly not confident that the electoral system will deliver them a majority. They privately think that this may not stop David Cameron coming into office at the head of a minority government that can secure a majority after a second general election that would be held quickly after the first.

If that does turn out to be the Conservative strategy after the General Election, then it may not be successful. The economic position of the UK is extremely fragile, and the political uncertainty that the likelihood of an early general election would create could tip the country into an economic crisis that is much worse than anything we have so far seen. It may be that Mr. Cameron simply can not afford to plunge the country into uncertainty.

For the Liberal Democrats a hung Parliament is both an opportunity and a serious threat. To an extent the position the party may take is also a function of what the electoral system delivers us. For example we have advanced in the national percentage that the party gains and still lose seats. Equally it is quite possible that our national percentage falls and yet we gain seats. In my view there is a significant chance that the party will indeed gain votes and if it does, I think there is grounds for optimism about nett gains of seats too. Indeed, I think it is only under such a circumstance that the Parliament is likely to be balanced anyway.

The message from election campaigns and indeed coalition negotiations in Scotland is that the party must focus on a clear set of core policies to insist upon as part of any agreement to support a minority government or even to enter into a coalition.

Thankfully, the Party seems to be distilling its agenda into four key principles that we can explain to both the electorate and the other parties as our bottom line.

The first is the key principle of political and constitutional reform. All parties now agree that significant changes are required to improve the functioning of our constitution. The Lib Dems ask for an electoral system that allows the voters to sack their MP without necessarily voting against their party: a change in the electoral system is fundamental to this. The Numbers of MPs should then be reduced by 150. The House of Lords should become a substantially elected body- albeit on a different franchise to that of the House of Commons. Strict rules need to be enacted against any no UK tax payer being allowed to sit in Parliament. Neither should big money and corrupt donors continue to be able to buy influence.

The second key principle is that taxation must be simplified dramatically- including a high personal tax threshold of £10,000. Taxes and benefits should be integrated to eliminate the poverty trap. The tax burden currently falls more on the poor than the rich. Fair taxes are an economic benefit as well as a social necessity.

While it is clear that overall levels of government expenditure will need to fall- and the Lib Dems would seek to close several Whitehall ministries outright- education should be protected from the general cuts. Schools in particular should be allowed to continue to invest, and class sizes overall should be reduced.

The fourth principle is that the government should promote investment in green technology in a way that makes the UK economy more sustainable and can create long term jobs.

Given the limited space that the Liberal Democrats usually get in the media, it is pretty much just these four principles: constitutional reform, tax reform, protect education, promote green technology that we will be able to convey against the noise and indifference of the media and the other parties contending for power. However they do represent a significant fraction of the Liberal Democrat agenda and the election will require us to set out simple and clear ideas.

Whether or not we can put Liberal principles into government in 2010n is still a function of the vagaries of the electoral system: this is also a year of economic uncertainty and in the face of this, all political questions are open.

Britain needs to change. It is not enough to change the party of government. The whole system of government needs radical reform. Liberals and Liberal Democrats have been arguing for this for over a century. It may be that now our time has finally come. Yet whatever happens over the next few weeks, come it will.

Wednesday, February 24, 2010

Estonia is a young country but a very old nation. Archeology and DNA suggests that the Estonians or their relatives have been on living on the shores of the Baltic Sea for several thousand years.

After being conquered in the early thirteenth century by the Teutonic Knights, the Estonians endured German rule under various overlords: Danish, Swedish, Polish, Russian until 1918.

The Germans- unlike the Normans who invaded England a hundred and forty years before- never assimilated with the local population, at least not linguistically, indeed until 1816 the Germans owned Estonians as slaves. However, the national awakening that followed the liberation of the serfs- nearly two generations before the rest of the Russian Empire- created a strong sense of cultural identity.

On February 24th, Estonia celebrates the point where culture, education and above all language found a political expression in independence. This independence was dearly bought, with wars against both Russia and German freikorps. Yet won it was. Although the Second world war brought occupation, first by Stalin, then by Hitler, then by Stalin again, still the Estonian people survived. Of the 92 years of the legal existence of Estonia, 45 years were under occupation by the Soviet Union. Arguably longer, since it was not until 1994 that the last Russian troops left the country. By the time of the 100th anniversary- in 2018- then only then will the Estonian times have lasted longer than the Soviet times. However it will only be in 2012 that the second independence will have lasted longer than the first.

However as we celebrate Estonia, we can begin to feel greater confidence that it is not just the huge achievements of the Estonians, in music, art, literature, the economy, culture and sport, that will be lasting, but the Estonian state itself. Estonia by a miracle was able to take her place amongst the nations in 1918, and by a further miracle to resume that place peacefully in 1991.

Historically Estonia was a bone of contention between Sweden and Russia. It is now a slight irony that Estonia, as a member of NATO, is defended by far greater military power than its former masters now possess.

Although the country faces challenges, it no longer faces an existential fight for survival- and that at least is great cause for celebration.

As I have noted before, the Conservative leadership is long on personal charm but very short of either executive experience or understanding of economics. The result has been a series of policies that are both inappropriate and constructed on little intellectual foundation. These flimsy policies- especially on tax- have broken apart at the first detailed examination. Stupid mistakes- missing decimal points, so that spending numbers are out by ten times order of magnitude- would not be happening if the Conservative Central Office policy units were on top of things: they clearly are not.

This, together with the rat-like cunning of Mandelson, has eaten into public confidence in Cameron. On top of this, it has been the Conservatives that have displayed the most egregious arrogance with regard to the MPs expenses scandal. From Sir Peter Viggars to Sir Nicholas Winterton, it has been Conservative MPs that have annoyed the public most. It must be very frustrating for "Team Cameron" to find themselves consistently blind sided by their own backwoodsmen. However the core of the responsibility for the declining fortunes of the Conservatives in the polls must lie with the failure of Cameron to provide key principles for his party to unite around. This rejection of core principles is not simply a rejection of "isms"- especially Thatcherism- it is a failure of leadership that has created sloppy thinking and drift at the heart of the Conservative Party.

Yet a casual observer might have thought that the election was the Conservatives to win. After all the economic crisis has happened on the Labour watch - and as Gordon Brown was Chancellor before he was Prime Minister, he carries a huge share of the blame. Neither is Mr. Brown a sympathetic figure: his volcanic temper has been a open secret for years. He is clearly a deeply driven, dark and strange man. He has alienated huge swathes of his own party. How could it be possible that the Conservatives can not beat him outright? Well, actually of course they probably will. According to the polls, the Conservatives are quite likely to out poll Labour by quite a big margin, but the seat allocation under our electoral system will probably not allow the Conservatives to gain a majority. In any event the contempt for Mr.Brown is not matched by a corresponding enthusiasm for Mr. Cameron

For the Conservatives, such a minority victory could be Pyrrhic indeed. The country faces a series of critical economic challenges.

Firstly it is now urgent that a credible timetable to reduce the government deficit is put into place. Failure to do so could lead to a Sterling crisis in the very short term, and emergency rate hikes that could create considerable disorder across the whole economy.

In any event, although the US and European Housing markets saw significant falls, the UK did not. The result is that the UK has one of the highest levels of household indebtedness in the world. House Prices in the UK, on virtually any measure- whether historic or comparable- look at least 20% overvalued. The tightening of credit in the wholesale market for mortgage banks- building societies- is leading to a sharp contraction in the availability of mortgages, and in any event the building society sector is unlikely to survive in its current form. The inevitability of rate rises makes the UK housing sector at a high risk of significant falls and again these could be disorderly.

Meanwhile the banking system that has been nationalised is still attempting to recapitalise itself, and this means that even nationalised banks are tightening credit, even as they continue to pay unwarranted bonuses for negative or non-existent performance. Unlike the USA, where the Fed seems set to make a profit on its investment in the sector, the UK is unlikely to see more than about 20% of its money returned. The supervision of the banking system will be critical, and the Conservatives have demonstrated an almost total ignorance of what needs to be done to limit the damage. They have also managed to alienate critical business and financial leaders through populist grandstanding rather than detailed policy formation.

Nor is British growth assured, the recovery is feeble, and a double dip is all too likely.

The crisis in the British economy is on the brink of becoming an emergency. The Conservatives are being weighed in the balance and may be found wanting. Their policy mistakes in opposition can not happen in government without serious consequences. A minority government would have its back against the wall from the start in the face of multiple economic breakdowns. Although some Conservatives are sanguine about a minority government, since they believe that they would get a majority in an election held quickly afterwards, they may underestimate the baptism of fire that any new government is going to receive.

Given the credibility of Vince Cable, it may be that they have little alternative but to turn to the Liberal Democrats.

Sunday, February 21, 2010

As we lead up to February 24th, Estonia's national day, I find myself thinking of last years song festival, and one of the more beautiful songs in the incredible choral tradition of Estonia is a setting of a poem by Juhan Liiv, as follows:

Saturday, February 20, 2010

A couple of days ago "Voter" linked to a blog he had written commenting on a piece I wrote here about my fears that the public sector in the UK is creating a client state that is undermining British global competitiveness. He -I assume he, and I am sure I will be corrected if not- made the point that breaking up the banks might not be the answer, since " Far from different banks behaving in completely different ways, there was some convergence. If banks converge, they are really just equivalent to one larger bank".

When it comes to understanding the failure of risk control that led to the credit crunch, I like to quote Chuck Prince, the then head of Citibank who famously said in June 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,”

Well, as we now know, the creation of various innovative instruments like CDOs did not reduced risk by sharing it out, it actually concentrated it into one space: liquidity risk. To explain what happened in 2008, let me use an analogy of owning a building. The building has let us say ten tenants. Of these you know that eight will always pay their rent no matter what. Then, suddenly, the two that you think are a bit doubtful do indeed stop paying rent. You have borrowed money to buy the building, but the reduced income you now have is still sufficient to pay back the loans. However, no one now wants to buy the building off you, and the result is that even though you are still receiving rent, the building is essentially worthless - the bank decides that it is not suitable collateral and withdraws its loans. Unless you can find other income, or post more collateral, then you are bankrupt- even though the building is still earning money. In essence this is what happened to the pooled products market, which brought down the banking system, even though by all reasonable measures before the crash, the failure of borrowers to pay should not have caused a meltdown. It should still have been possible to refinance the shortfall. However, what actually happened was that although the instruments were novel, what they had done was to increase the level of credit beyond the level of liquidity. When everyone tried to sell, the securities became worthless.

The next question is why then did a meltdown in the CDO market cause the collapse of the banking system? The problem was that the meltdown in the US property market rendered the mortgage backed component of CDOs worthless, so in order to raise money, the other underlying securities- AAA sovereign bonds for example- were sold at fire sale prices. The whole bond market went into meltdown. So even though the trading firms believed that they had pools of valuable assets they could not sell them, and so the short term margin calls began to overwhelm them. Bear Stearns was the first house that needed to be rescued. However the rescue of Lehman Brothers could not be arranged in time, and they went broke. This caused immediate panic. It became clear that the company that insured the value of these securities- AIG- could not meet its obligations. Huge quantities of all securities were dumped as every house sought to find liquidity. trading lines were cut and the system would have failed completely unless the global central banks, led by the Fed, had not stepped in.

Liquidity risk- the ability to freely market securities for some price- had been taken for granted. In fact no bank had created a stress test based on total market failure- which was why Chuck Prince though he could keep dancing, even though he knew that liquidity could be a problem, he did not understand that it was already at a critical point, and that he would end up not just writing down the value of his securities, but writing them off altogether.

Now, Voter asks, how can we stop this kind of group think destroying the market in the future? Firstly, both regulators and the banks themselves have learned that the multi-business bank model: originating loans and then selling them on in packaged securities has much greater systemic risk than was previously understood. There are much more extensive stress tests based on liquidity than there were before. Secondly it is important to recognise that in fact not all banks actually did respond in the same way and nor were they equally affected. Both Goldman Sachs and JP Morgan had drastically lower levels of exposure to the MBS and CDO markets than their competitors. Although the market was focusing on the efficiency of capital allocation, which is what these innovative products were supposed to improve, in fact many bankers made a strategic decision to reduce their risk exposure to the CDO market well ahead of the crash. That these banks also needed some TARP money was because they were caught up in the general market rout, not because of their specific risk.

Nevertheless the risk profile in loan origination versus loan ownership is completely different- and shareholders are waking up to the idea that the need much higher returns to justify their investment in higher risk businesses. It is that which will help to discipline the business in the future. One can certainly understand why regulators suggested that many bank shareholders behaved "like absentee landlords" - failing to police the value of their assets, but those shareholders were punished by either the drastic fall in the value of their shares or indeed their total loss. Frankly, since in many cases it is the government that owns the largest banks, the various finance ministries should now start to focus on maximising their investment: and giving employees a blank cheque to be paid more than the owners is the first thing that should now stop.

The strange thing about the banking crisis is that bank shareholders did not actually hold their employees to account. The whole point of the capitalist system is that it works when people act in their own self interest. The banks did not- most of them kept on "dancing" long after it was becoming clear that the orchestra was playing bum notes. If it is the case that shareholders were not able to understand the assets that they owned, then why did they bid up the prices, both of the assets and indeed the banks themselves so much?

In the end the markets, where some of the best minds hunted for profits so avidly, turned out to be turkeys. That in itself will discipline future investors to ask more searching questions. Secondly the propagation of risk across the system turned out to to be so extensive that not just individual banks needed to be rescued, but the whole system. In the future regulators will understand that better, and proposals such as the Tobin tax will reduce the profitability and therefore the attractiveness of such business while also in theory allowing regulators to amass fire power before a crisis actually happens. Thirdly, owners of lower risk businesses will seek to make sure that their business is not undermined as the result of an allied higher risk business. Branch banks were separated from market banks in the US, and although I see no formal return to Glass Steagall, I do see greater understanding of this risk problem.

The fear I have now is not that the banking system will make the same mistakes, but rather that the new environment of more intrusive regulation will warp the market in different ways and lead to governments becoming more involved and much more exposed to businesses that should not be the preserve of the state. Once the system is re privatised, I want to see clear and simple regulation, with clear boundaries about where the responsibilities of the regulator stop, and those of the shareholder begin. With the banks in the UK at least now largely state owned, I fear that the position could be blurred and that the taxpayer could be left with unknown legacy issues long after privatisation has come and gone.

So in final answer to Voter, I would say that you are right, there was a systemic failure, not just a failure of any given bank, but that the solution lies partly in greater diversity- in operations and ownership of different bank businesses that have recently been grouped under one umbrella. In the end both regulators and owners of these businesses have learned bitter lessons, but there is still at the moment too great a mixture of different risks in the larger banking groups. In my view these risk groups need to be separated, and that shareholders, acting in their own interests will do this. If they do not, then only then do I think that regulation will be required.

In the end though, the returns of the banking sector have proven to be illusory. As Nassim Nicholas Taleb points out, all the profits of all of the banks for all of the 20th Century were wiped out by the crash. If that, as an investor does not give you pause for thought about the whole basis of banking, then do by all means feel free to invest in the banking system now. I, however will not be joining you until I understand what the specific and systemic risks of any given bank and the banking system itself actually are.

Friday, February 19, 2010

As always, the most juicy bits are the salaries. In transport for London (TfL), for example there are 231 people are paid more than £100,000. The UK Treasury has 21.

Meanwhile it may be worth remembering that an MP has a salary of £64,766.

The Chief Executive of Shrewsbury Council earned £335,000 last year. The Head of TfL earned £494,884

It may be worth recalling that the Prime Minister earned £197,689.

Although I think "Sir" Nicholas Winterton has been one of the more egregious expenses cheats, and a pompous ass to boot, the media shit storm about his annoyance at losing his free first class rail travel seems a bit overdone. After all first class rail travel is a privilege that is extended to all officers in the army above the rank of Major.

MPs have become every one's whipping post, but at least 80% of them try to do a good job in not particularly great working conditions and actually quite poor remuneration, when one considers the rest of the public sector.

I, for one, hope that the new Parliament resents the outrageous larding of public sector pay and conditions so much that this is where they start the bonfire of the public sector vanities.

Thursday, February 18, 2010

I don't quite know why my infantile funny bone so enjoyed the debate over a place name in Yorkshire. Perhaps it is because I have been watching videos of Open All Hours, and could imagine the reverend tones with which the debate over Tickle Cock Bridge must have been conducted.

It took me back to my childhood, when we might find names like Christmas Pie amusing and names like Wyre Piddle laugh-out-loud hilarious. Indeed we would take a detour to go through it.

There are, after all a plethora of amusing names across Britain, from Middle Wallop, to Lower Slaughter to the Paps of Jura (though why there are three of those, and only one Pap of Glencoe has always puzzled me). From Muckle Flugga to Mousehole, the UK is filled with the bizarre, the odd and the downright filthy. Indeed the whole world- from Arsoli in Italy to Wankie in Zimbabwe- is your oyster when it comes to place name filth.

Of course street names too have their fair share of the curious, and Tickle Cock Bridge is only the latest in a long line of -shall we say allusive- street names. It is a fair bet that any Maiden Lane in the Kingdom once had a riper moniker- but Grape Lane in York is probably my favourite.

Tuesday, February 16, 2010

Once upon a time, the political discourse in the UK was all about it. Now it is scorned: deregulation is considered to be one of the major causes of the economic crisis that we now face. Yet how can free enterprise be considered to be triumphant when the number of people working in the private sector is at its lowest level in over a generation? It is as though the Thatcherite revolution had never happened. Britain is now dominated by not just state power, but state ownership.

I hold a few non executive directorships in businesses that I believe in. As a result I am on a register- a mailing list for people seeking to take on other non executive roles. I would say that more than half of the non executive roles that are advertised are in state or quasi-state bodies: NHS Trusts and the like. Nor are these the sinecures that you might imagine- the remuneration that one can expect from a state body is higher than the equivalent in the private sector. In the NHS alone there is a supervisory payroll of tens of thousands of people whose combined remuneration is at least a billion pounds.

Yet this supervisory regime fails to ask the most basic questions: "is this expenditure actually necessary?" The result has been an extraordinary expansion in the scope and costs, not just of NHS activity, but the entire public sector. We have workers who are paid more than their private sector colleagues and who also have more job security and generally better conditions. We have an army of directors and administrators who are exceptional well remunerated. We have suppliers who gold plate their contracts, safe in the knowledge that expenditure is not properly queried. In short there are now millions of Britons who have a huge vested interest in the perpetuation of a monstrously expensive and very wasteful public sector.

What then about the perceived failures of deregulation?

There is no doubt that bad regulation in the financial sector failed to control dangerously excessive risk taking. There is equally no doubt that the banks who took such excessive risks bankrupted themselves. In a genuinely capitalist system, they would have ceased trading. The problem was that if they had ceased trading, then the impact would have meant economic collapse becoming a real possibility. Now, as the newly state owned banks begin to work themselves out of their debts, we discover that the staff are not accountable to the shareholders- that they continue to reward themselves with large payments for failure. Yet, in my view, this is not a regulatory issue. The private shareholders should have investigated their asset more carefully- and there remains every regulatory power for them to do so. The state shareholders should have said no to excessive demands until the bank is private once more- and to have skewed remuneration to that end. The fact is that the banks have continued to prop up the housing market, even though the tsunami of debt is already visible on the horizon- a tsunami that will wash away both mortgage banks and house prices.

Again this is not a regulatory issue: it is at least partly the fact that the banks have no moral hazard now they know that the state will back them no matter what.

The state believes that it knows best. It has supervised and intruded on an ever larger part of society and the economy. It has backed banks when it should be pulling them apart into smaller and more manageable sizes- which is what the market would have done without state involvement. The state has concentrated risk still further, and the danger is growing of a second bank meltdown.

All the resources of the British government are not enough to stave off a further credit crunch and a further fall in the value of the Pound. The increase in inflation shows you that the economy is losing efficiency and competitiveness every month.

The only way to even begin to fix this is to alter the fundamental structure of the British economy. To disband the power of the state dramatically across the board. The alternative is the breakdown of the economy.

The question is whether those millions who have become wealthy clients of the public sector understand the fact that the party is over, or whether they will continue to treat the the country as a bottomless pit.

But it is not just corporations that go bankrupt: it can happen to countries too: Mexico, Argentina, Poland are just a few examples.

When an enterprise goes broke, it hurts the employees and the shareholders. When a state goes under, it hurts everyone.

Monday, February 15, 2010

It is a general Election that the Conservative Party is expecting and indeed is expected to win.

Why then is the Tory Party in such an incredible mess?

There is no sense of coherence anywhere- policies are made up with great rapidity, and abandoned within a few days of announcement. It is not just that the Tories are "keeping their powder dry" for government- they genuinely don't know what they are going to do. They insist that they will be fiscally disciplined, then return from Davos feverishly back pedalling on what should be a central part of their economic policy. They announce tax policies that crumble in a single weekend.

The latest "policy announcement" is that employees in the public sector will be allowed to form co-operatives. A fine idea in principle, but there is absolutely no sense that the Conservatives understand the first thing about the details. It is impossible to even critique the policy, because it has clearly been dreamt up within the past few days- and this upon the eve of a transition to government!!

This is an absolute disgrace.

Gimmicky, stupid and dangerous policies are being thrown around because the Conservative Party exists in an intellectual vacuum. Where is the sense of unity of ideology? Where is the sense of focus?

There isn't one.

Frankly it is absolutely contemptible to watch a bunch of Public Relations airheads totally destroy their credibility. I hold no brief for Gordon Brown. I do not want any more Socialism in the UK. I do not want to see a Labour Government after the next elections. However this appalling display of infantile gesture politics amongst the Tories makes me increasingly certain that the young politicians on the make in the Conservative Party will be just as disastrous as the Blair-Brown fiasco.

Of course large numbers of Conservatives also feel the same way. The latest internal party fiasco was in Westminster North, where the Conservative candidate- whose immature style of "tweeting" makes her sound about 14- needed to be rescued from her own resignation through the intervention of Cameron himself. Frankly the Westminster Tories are an unappealing lot at the best of times but I did have a certain sympathy for the local constituency chairwoman (now removed from office) who clearly found the candidate extremely hard to take. The disillusion with Cameron in her statement was quite obvious- and all of this is well before Mr. Cameron can be certain of becoming Prime Minister.

The empty headed Cameron project is headed for a wreck upon the rocks of its own vacuity. If History does indeed repeat itself, "first as tragedy, then as farce", then the self-styled heir to Blair will be a failure on an industrially farcial scale.

Ground hog day has come and gone and seems to predict another six weeks of winter- at least for Pennsylvania. Here in Estonia we don't really need rodents to tell us that the winter is going to stay for a while longer. Yet the quality of the winter is changing. The extraordinary darkness of December is gradually giving way to lighter days. At this time of the year, the length of the days grows very rapidly- a good five minutes extra daylight each day, so that even over a week or so, the feeling grows stronger that the near total daylight of high summer is on its way.

Yet, the winter itself continues with full force. It has been exceptionally cold and exceptionally snowy. As I write, the snow on my balcony is about a metre deep, and the piles of cleared snow in the car park top three metres. The skies are lowering grey with the promise of yet more of the white stuff. Yesterday was a clear, crisp day with the bright sunshine reflected on the white carpet in motes of diamond fire.

Taking a walk- slowly picking across icy and snow obstructed pavements- I came to the sea. There is a broken carapace of pack ice across the Bay of Tallinn. The dark channels of open water that are cleared to allow the ferries enter the harbour steamed in the cold. The view across to Viimsi peninsula seemed strangely foreshortened by the ridges on the ice, where the swans and other sea birds scrambled about in what seemed like a rather chilly misery. Yet everywhere there was light, the snow and the ice dazzling under the blazing sun.

The seasons are slowly turning and though we are winter-fatigued, longing to throw off the heavy winter coats, scarves, gloves, hats; at least the light gives promise of the brief, precious summer days that are coming.

Friday, February 12, 2010

The apparent suicide of fashion designer Alexander MacQueen is a private tragedy. The combination of over work, grief for the recent death of friends and on the eve of the funeral of his mother, the designer seems to- sadly- have decided that he could not go on.

The reaction to this private tragedy amongst the fashionistas was so excessive, so narcissistic, so overblown, that I found myself struggling to hold back a profound anger. Even the Today programme on BBC Radio 4- which I can listen to here in Estonia via the Internet- devoted nearly ten minutes of the prime 7.45 slot to interviews with participants at the New York fashion week- picking up reaction from interview and tweet with a remarkable lack of discrimination.

I suppose one should expect a business devoted to how one looks to be more than a little narcissistic, but the baroque emotions on display made me suspect that the shell of excess concealed an unfeeling vacuum. A remarkably appropriate metaphor for the whole fashion industry you might think. We already know about the powerful egos and titanic struggles of the fashion world- "The Devils wears Prada", "Ugly Betty", and the well publicised antics of Anna "Nuclear" Wintour, the supposedly all powerful editor of American Vogue, have etched these upon the popular consciousness.

To what end? Well- mostly- money. The fashion business in the UK is one of its largest earners, and the few lionised designers- like Alexander MacQueen himself- are indeed a valuable commodity. The inventive language of the fashion critic as each seasonal collection passes is simply a rather saccharine coating for the question of hard cash: how commercial will the flights of fancy on the catwalk become?

As yet another ratchet-jaw emoted over the power of S&M in fashion design I felt an incredible rage rising in me. I respect the power of money as much as the next man, but the fact is that fashion is a luxury, not an essential. Agonising over hemlines or fabric is something that only the very rich can do. For as much as one considers the vocabulary of fashion: the drama of its grandiloquence, it has no higher spiritual purpose. Indeed I began to understand why the puritans were so against the frou-frous of their cavalier contemporaries. Moral judgements are being made about fashion, but fashion has no moral purpose. It seemed to me that our society places excessive value upon the trivialities of the passing whims of fashion.

Then I thought -ruefully- that my anger was just the grumpiness of a deeply unfashionable middle aged man. The gaudiness and shallowness brightens the world with tinsel in the same way that a Magpie brightens its nest with stolen trinkets. Perhaps I should be more forgiving?

In Port-au-Prince last night it rained. It is one month since the earthquake. The death toll is now higher than the boxing day tsunami- around 230,000 people. There is not enough shelter, and the badly injured are being treated in fields where necessary. The total GDP of Haiti is less than 5% of the size of the fashion industry. But no one in New York was too worried about hemlines in Port-au-Prince- they don't spend enough on designer labels in Haiti.

Thursday, February 11, 2010

12 years ago Hector Sants was my boss. Strictly speaking, my direct boss was his deputy, but across the football field size of the UBS equity trading floor at 100 Liverpool St. everyone knew that this tall, solid figure was the Boss. He was not -in the manner of many City Bosses- a flamboyant, loud or bullying figure. He was measured, he was intensely intelligent, he was very, very competent. In short he still stands out today as someone who understood the business of the City with forensic clarity. His slow voice, with just a trace of the West of England in it, was not the loudest in any discussions-but once he had listened, and made his judgement, his decision was usually right and was always respected. He understood complexity and was impatient with the glib statement or facile judgement. He would quickly identify mistakes and even more quickly move to correct them. The shot gun marriage of UBS to SBC in 1998 was the result of terrible misjudgements in Zurich and not in London.

In the end, his obvious competence was why he was tapped to take on the role of head of the FSA- the Financial Services Authority- the City regulator. Unlike many who take on such roles he neither needed the prestige nor the money. He does, however, have a strong moral sense of doing the right thing and he is also, in his quiet and understated way, quite patriotic. He chose to give something back.

He has, as head of the FSA, faced a financial crisis on a scale unseen for over three generations. He is generally agreed to have acquitted himself well- his competence and determination contrasting with many others in public and financial life. In the end, as he had said he would, he has chosen to leave the FSA after three years.

The question is why Hector could not be persuaded to stay. I think there is no doubt that the decision of the Conservatives to abolish the FSA and unify the financial regulatory system under the Bank of England is the root cause. There are- to be frank- many pros and cons about this, and it is certainly quite arguable as to whether it is a good or a bad move. However I think what concerns the City is that the decision seems to have been taken by George Osborne without having a debate and fully understanding the price of creating several years of regulatory upheaval right at the time when the entire system is badly in need of consistency and stability. In short it is at least as much the way that the -apparently irrevocable- decision has been made, without due consideration, as the decision itself, that worries City practitioners.

Even though the financial system has undergone massive upheaval, it is not true to say that all bankers are incompetent charlatans- and when it is politicians who are ladling out such abuse, it is probably fair to say that the political class has much to hide and should probably take its full share of the blame. Either way, unquestionably respected figures like Hector Sants should not be ignored and then shrilly derided by a young and inexperienced politician on the make.

Many commentators are suggesting that Hector's departure looks bad for the Conservatives.

It not only looks bad. It is bad.

It is a further misstep from the accident-prone shadow chancellor. Mr. Osborne is not exactly respected in the City as it stands. Another clanger like this and very serious questions will be raised about Mr. Osborne's temperament, his judgement, and indeed his competence.

Tuesday, February 09, 2010

ViktorYanukovich - the likely victor in the Ukrainian Presidential election- is not a Jeffersonian Democrat. He carries with him the air of the youthful hoodlum he once was- he served time in gaol as a young man. However YuliaTimoshenko- the defeated candidate is hardly a model democrat herself. It would be quite easy to throw up ones hands and say that Ukraine was a lost cause and that it has not escaped its terrible past.

Easy but wrong.

For one thing, the Presidential election has been given a clean bill of health by election observers. A clean election anywhere in the former Soviet Union is sufficiently rare to be celebrated. Neither is Ukraine likely to fall under the control of Russia, despite fears that it may do so. The fact is that the division of Ukraine has proven to be its saviour. No one party, region, or faction -still less a single individual- is able to control the country. All things must be negotiated, all things are political. On the one hand it creates a slow moving, quite badly governed state, with low level corruption endemic, on the other Ukraine is classified as free by Freedom House.

So Mr. Yanukovich, even if he wanted to deliver Ukraine to the Kremlin could not do so. He must govern by way of deal making and compromise, and for every die-hard pro-Putinista in Ukraine, there are probably three pro Europeans. The economy is now oriented to its prosperous Western neighbours, not its inefficient and truculent Eastern. However much Russia tries to project its will in K'yev, it finds that it must, like everyone else, cut a deal and negotiate, and in fact it has few things that are attractive to Ukrainians. Even the energy weapon is a two edged sword for Russia, for blackmailing Ukraine reminds the West of the importance of diversity of energy supply and diminishes Russia's reputation as a reliable supplier of energy.

Neither can Mr. Yanukovich, even if he wanted to, create a more authoritarian constitution and bend the Ukrainian people to his will. The local regions are powerful, and whether Russian or Ukrainian speaking, they will not easily cede power back to the centre. On top of that, creating a more centralised state could deliver Mr. Yanukovich into the hands of his political opponents, since the Orange Revolution, for all its disappointments, has shown that a President who oversteps the mark can be removed by the popular will.

So, in the end it is likely that it will be economics that is Ukraine's destiny: and that means a continued Western trajectory- whether or not the Kremlin or indeed Mr. Yanukovich want to stop this or not. In fact, there is some evidence that Mr. Yanukovich has learned plenty of lessons from the Orange revolution- which Ms. Timoshenko may not. One of the most obvious is to try to construct coalitions, which Mr. Yanukovich has already done to a degree with the outgoing President, Mr. Yushchenko. The second is the increasing use that Mr. Yanukovich makes of the Ukrainian rather than the Russian language. Like Ms. Timoshenko, Mr. Yanukovich learned Ukrainian as a second language, unlike her, he still stumbles over the language, but nevertheless, he increasingly uses Ukrainian in public. Although he has stated that he would like to see restrictions against Russian lifted, which would please the Kremlin, this is simply to put the issue on the agenda, not to actually enact change. Even in such relatively minor changes, Mr. Yanukovich will need to negotiate and not to decree.

So the mood music in Ukraine will change. Mr. Yanukovich is not a cultured nor notably intelligent figure. His thuggish demeanour and past will tell against him. However the Ukrainian people have freely elected him as their President. he may not be Thomas Jefferson, but in the end he doesn't need to be. The Ukrainians are asking for better governance, and that Mr. Yanukovich may yet be able to give.

The Western trajectory of Ukraine is secure. The rest is details. Even an undemocratic and unfree Russia can only negotiate for influence in a democratic and free Ukraine, it may not force the Ukrainians to act against their will. In the end, that is the final and the greatest triumph of the orange revolution.

Monday, February 08, 2010

The first part of the economic crisis which began in early 2008 was the meltdown of the US mortgage market. This led to a breakdown in the asset backed securities market, which could no longer rely on the collateral of US mortgages. This in turn saw the breakdown of the balance sheets of the major trading banks, the forced takeover of Bear Sterns, followed by the bankruptcy of Lehman Brothers and the collapse of AIG. This forced governments to initiate rescue programmes for those banks most exposed to the secondary debt markets.

The last year has seen governments taking on colossal amounts of debt to try to recapitalise the banking system and avoid a 1930s style depression.

Unfortunately, this has not solved the problem, it has only moved it about.

Although the global economy is now no longer at risk of a synchronized collapse in GDP, those economies that are not competitive are now facing a very testing time. If Greece was not in the Eurozone, it would probably have already faced a currency crisis. But under the fixed currency system, it now faces an even more serious problem: defaulting on its debts, unless the other members of the Eurozone provide new credit lines.

This week we will find out whether or not the Eurozone can hold together in its current form.

The fact is that the global markets are not prepared to fund countries that are continuing to expand their debts without significant structural reform. Unless Greece, or Spain or Portugal address their structural inefficiency, they have already reached the end of the road. Neither is the UK in any better shape. Unless the country unveils serious plans to address its ballooning debts, then the UK is in the same boat as the Eurozone: this is a debt crisis based on economic, structural fundamentals at least as much as it is a simple currency crisis.

Ironically, some might say, the crisis that began with the collapse in US property is now leading to a debt crisis in Europe the like of which we have not seen since the bankruptcy of the Austrian Credit-Anstalt in 1931. While the United States continues to recover, the European economies are now set to face a severe escalation in the scale of the crisis.

Without emergency action to reassure the markets about the cohesion of the Eurozone, there could be a total meltdown in the Club Med debt and equity markets over the next few days, confidence is now so fragile. Even with decisive action from Berlin, the markets are so spooked that there will be continued fears over the stability of the Euro for some time to come. Without action from Germany, we could see a sovereign debt default that would make anything we have seen so far look like pretty small beer. The squeeze from such a default would put back any sustained recovery in Europe, including the UK, towards the middle of the decade.

This next month is set to see major market volatility. The markets have got very scared indeed.

Saturday, February 06, 2010

The Greek crisis continues to develop. After the implosion in their public finances which was revealed after they stopped faking the numbers, the markets have taken fright at the scale of the problems in Athens. So far so unsurprising: Greek public finances have been weak or very weak for decades. However, there is now a strict discipline that Athens must adhere to: membership of the Euro. Instead of printing money and getting out of trouble by devaluing the Drachma, the Greek government must now impose tight fiscal discipline, despite the grim outlook for economic growth.

Many Anglo-Saxon commentators do not believe that the Greek government: beset with strong Unions and a poisonous legacy of corruption will be able to do so. Several others do not think that they should even try. The problem is that without cutting the deficit, the country faces a stark choice: either fail to repay their debts- i.e. to default- or to abandon the Euro altogether. The Anti-Euro cheerleaders are hopeful that Greece will choose the latter road, and that the single currency will be crippled as a result.

The problem is that introducing a new Drachma would be creating a literally worthless currency- it would have little resources and less confidence to back it. Greek businesses would probably be unwilling to be paid in New Drachmas, and the Euro would continue in general circulation. There would be a real risk that Greece would enter hyper-inflation in the new currency and create crippling economic damage for itself. There really is no alternative but for Greece to continue to use the single currency- so the focus is now on trying to plug the hole in the economy and create some kind of international bail-out. In that sense, Greece is probably "too small to fail". The Greek economy is a relatively small part of the Eurozone and co-ordination between the ECB, the IMF and World Bank should be able to give the Greek government enough breathing space to start the process of reordering their public finances.

The problem will become far more serious if other Eurozone economies begin to suffer the Greek meltdown: and the huge instability in the markets last week shows that fears are gathering around Spain. Spain is a significant part of the Eurozone, and any rescue would require the real commitment of Germany in order to happen- and the mood music in Berlin suggests that there is a limit to German patience and understanding.

The reasons why Germans are imposing limits are not hard to see. Germany, over the past decade, has imposed upon itself a large scale structural reform of the labour market: it has been a difficult and at times painful process. However the Club Med states have not imposed such structural changes: in the name of social cohesiveness, jobs became permanent but unemployment rocketed. The productivity of Germany improved dramatically, but that of Italy, Spain or Greece fell dramatically. The Germans learned the lesson that the fixed currency demands much greater flexibility in every other area of the economy. The Greeks and the Spanish did not learn that lesson- and now the burden of that failure is crushing the life out of their state budgets at a time of general economic gloom.

However, the smugness of many British commentators is ill founded. "Look" they say "how lucky we are not to be members of the Euro, because we too could have been in the same position as Greece- and unable to devalue our currency". Yet the fact is that our much vaunted "currency flexibility" is as much a curse as a blessing. Leaving aside the morality of whether governments should be allowed to debauch the value of the currency it issues, the fact is that even the 30% fall in Sterling has not been enough to avoid the longest and deepest recession in the developed world. Despite maintaining an independent currency, the British economy has massively lost competitiveness- and for the same reasons as Spain and Greece. We have created a massive state sector of startling inefficiency, and after the fall of our largest industry- banking and finance- Britain has very limited competitive advantage. The national debt has doubled in two years, the deficit- at around 16%- is actually worse than Greece. The fact is that even while the devaluation of Sterling has reduced the impact of our folly- the UK is on the road to ruin, independent currency or not.

The Greek and the Spanish crisis is not about the impact of the single currency, it is about a failure to implement necessary economic and strategic reform. It is about a failure to deal with huge pension deficits in an ageing population, it is about a failure to diversify the economy and to create a more flexible micro-economic environment. Whether or not the single currency survives is really beside the point: the fact is that these changes have been delayed too long, and therein lies the root of the problem.

As for the UK? Well almost all of the same questions apply. The failure to address pensions has destroyed the competitiveness of the British Economy: British Airways being the most obvious example. The massive increase in the power of the state, and the expansion of state economic activity to the levels of East Germany is beyond the long term capacity of the State to finance. Placing so many of our best brains into the accounting and City underlines the lack of diversity of our own economy- and looks way too much like putting all our eggs in one basket.

In my view- however reluctantly- the Germans will try to steady the Euro ship. The price will be high: make the necessary reforms or else leave the single currency. The so-called PIIGS states have little option but to comply: indeed Ireland already has done so.

As for Britain? We have given ourselves a breathing space at the expense of a third of our nominal wealth. Unless we address our structural weaknesses and wean ourselves from our dependence on the state sector, then the outlook is very bleak indeed. Higher inflation, lower competitiveness, and continued decline.

In the end the crisis of 2010 is not a currency crisis- it is a fundamental economic crisis. Without truly addressing our deficit and the imbalances that caused it: being "tough on the deficit and tough on the causes of the deficit", then the value of the Pound versus the Euro will continue to drain away. We have gained an advantage from possessing an independent currency- the breathing space to reform. The price is that unless we use that breathing space to enact radical restructuring across the economy we will be permanently poorer, and clutching a currency that no one trusts or uses.

Thursday, February 04, 2010

it has been a pretty ho-hum week for David Cameron. Despite a good performance on Prime Minister's question time, he has had to consider a swathe of polls all showing Labour support up, and the Conservatives down. Many Conservative commentators are coming out of the woodwork to give advice to Mr. Cameron- and the chorus has increased in intensity with every percentage point the Tory lead falls. Amongst the various voices trying to steady the ship, there is a growing voice of simple perplexity: "how", they think, "can the Tory lead be in danger, when Labour has so manifestly failed?" Benedict Brogan's piece in the Telegraph this morning is a classic of the breed.

And of course he is right: Labour has failed, and the voters are indeed heartily sick of Gordon Brown. But that is not the same as saying a Conservative victory is inevitable, or even desirable.

Fraser Nelson in the Times, I think, comes quite close to explaining why. He points out that winning office and winning power are two different things. A successful Prime Minister has a clear and usually radical agenda from the very beginning. The problem that Nelson identifies- and I have blogged about this before- is that the Conservative front bench are so focused on winning the election that they have adopted Labour nostrums wholesale and have been far to timid in voicing a clear vision for what they would do in office, should they win. Touting a one billion pound spending cut is a bat squeak compared to the roar of a one hundred and sixty billion pound deficit- and claiming such a pin prick as a "radical solution" is simply ridiculous.

Nor is David Cameron winning any plaudits for his vision of political reform. This morning he writes, reiterating his opposition to electoral reform - and of course he is right to oppose the cheap Labour chicanery on the issue. However his own vision is scarcely more coherent - the root of the problem of expenses and all the rest of it, is that the majority of our MPs represent "safe seats": they can not be held accountable. Without a full scale programme of constitutional reform, including voting reform, the political gap between the governed and the governors will continue to grow, even if there are 10% fewer Members of Parliament. You could argue that political reform is the unfinished business of the Thatcherite reforms: she was prepared to open any market to greater competition, sweeping away swathes of Spanish practices- sometimes even too radically- but the one place she failed to introduce any reforms at all to, was the political system- with malevolent consequences that are now obvious.

So Fraser Nelson is right, in a sense, the Conservatives are in great danger of being too timid, not only too timid to win power, but if the polls fall further even too timid to win office either. But I think that he is probably wrong to hope for change from a Conservative leadership that is too comfortable- even self satisfied- to understand that the state of the country is now bringing us to a crossroads where all choices have serious consequences and all solutions must be radical.

In a sense a new political front is opening up: a clear gap between the statists- of all parties- and the radicals. I am a classical Liberal, but recognise that there are liberals in other parties too. I think that if we do indeed have an inconclusive election then it will be important for radicals across the current political spectrum to reach out to each other and forge a common agenda.

For me, failing to "trust the people" has led to the nanny state agenda and a huge and more sinister reduction in personal freedom to the benefit of the big state. Labour is set to increase the power of the state even further, but the Conservative leadership too is ducking the issue. They have, as Fraser Nelson points out, taken on too much of the syntax of New Labour to be able to challenge the system in the radical way that it requires.

While my own party too needs to be more clearly explicit about the reduction in the power of the state that we want to see, at least the Liberal Democrats have put forward policies that understand the need to cut drastically the spending programmes currently under way. Indeed we have even cut policy commitments that are dear to our hearts, because we know that there is no point- the money simply isn't available.

What I would say to liberals in the Conservative Party is that it is not enough to speak fitly or be silent wisely. It is absurd that radicals now have to look to John Redwood for leadership- and a reflection of just how marginalised the liberal voice has become, that there are no others willing to speak out.

If Fraser Nelson and those like him are disappointed now, I fear that they will be utterly disillusioned after a year of any Conservative government. Only real, radical reform can address the political and economic crisis that our country faces- and the timidity of the Cameroons is simply not enough.

While I understand the feeling that speaking out now might be seen as damaging the prospects of the party within weeks of the election, the fact is that those prospects are in the balance because of a failure to speak out earlier. Fortune favours the bold, not the timid, which is why the Conservative commentariat is rightly concerned about the way things look as we stand on the brink of a decisive general election.

I think as Liberal Democrats we can hold ourselves back from the not-particularly-appetising morsel of AV- which is not necessarily fairer than First-Past-the-Post, and is anyway considerably more closed, since it relies on Party lists.

A Single Transferable Vote (STV) in multi-member constituencies is what the Lib Dems want: since it retains constituency links, is not reliant on lists, allows non party figures to be elected and allows the voters to chose between candidates of the same party, rather than having party hacks foisted on them willy-nilly. It is the fairest and most open electoral system and will actually produce a Parliament that reflects how people vote.

After being strung along by Blair and now Brown, I don't think any of us are in the mood to offer Labour any support for their half baked, crooked little scheme.

The message is clear: if people want to reform our political system, they should vote for the party that consistently advocates political reform -the Liberal Democrats- and not for a government that treats electoral reform as a way to try to save their own miserable skins.

Sure David Cameron does not support political reform, but, guess what? Neither does Gordon Brown. All that has happened is that a pathetic, cowardly and miserable government has yet again demonstrated why the cynical politics of Blair, Brown and Mandelson have long since passed their sell-by date.

Monday, February 01, 2010

The new year seems to give rise to new economic forecasts, as people try to guess what the next few months will hold. Now we are into February, the game seems to be correcting previous forecasts, and so it has been going with UK house prices. This hardy perennial of boring dinner parties seems to be a particular focus right now, and yet it is clear that all is not well. The latest forecasts seem to show that the British economy will recover and that house prices will recover even more quickly. Except that House prices have not actually fallen too much in the first place. The latest (revised) forecast from CEBR is that house prices will rise a further 6% over the course of 2010. If so, then that is a potentially very dangerous number.

An average salary in the UK is, depending on how you measure it, just under £30,000 a year before taxes. The average property price is roughly £130,000. This represents an earnings: house price ratio of roughly 4.3x. This in itself is quite a high ratio historically, and even allowing for savings and previous equity, it also implies a high level of average mortgage debt. This is particularly true recently, because of the high levels of loan:value that banks were prepared to offer on mortgages over the past decade.

However, such large debts are still supportable on an average income if interest rates remain low. Over the course of 2008 and 2009, interest rates fell dramatically, with the result that the "affordability" of homes increased dramatically, that is to say the proportion of income used to fund mortgage debt fell sharply, as interest rates touched bottom. The result has been that many households have actually found themselves dramatically better off despite the severity of the crisis.

On the back of this, commentators are now predicting that the general economic recovery will indeed bring a more vigorous housing market. It could certainly be the case that there will be a short term spike in house prices, because there is clearly a low level of current supply. The reasons for this are complex, but amongst others, there is the fact that many are now locked into low fixed mortgages that they would have to re-peg upwards were they to move house, which is a strong incentive not to move at all.

Nevertheless there are several constraints on the UK housing market which I believe make the current optimism irrelevant. The first is that although the UK state debt has increased massively: from roughly £450 billion to roughly £900 billion over the course of the past two and a half years, this is dwarfed by the over £4.6 trillion of total British indebtedness. Household debt is a multiple of the government number. While it is true that there was a certain amount of de-leveraging of personal debt, with a sharp reduction of credit card debt being seen in the early part of the crisis, the c. 10% increase in house prices over 2009 has cancelled this out, and indeed the lower interest rates are now fuelling personal expenditure too: and the result is a sharp acceleration personal debt (and not co-incidentally in UK inflation too).

The British are returning to their bad old profligate ways. But why does this matter? The answer lies in revisiting the total debt number: roughly £4.6 trillion. This is a debt to GDP ratio of 466%. In the developed world, only Japan has a higher debt:GDP ratio (roughly 470%). The United States has roughly 300%, while Germany's debt: GDP is roughly 280%. The level of British debt is very high overall, and with the government deficit for 2010 now forecast to be over £120 billion- a higher percentage deficit than Greece- the UK is also increasing its level of debt at a faster rate than virtually any other developed economy.

The Bank of England has dramatically increased the money supply, through its quantitative easing programme and the government has run huge deficits, both policies designed to stimulate economic activity. Both policies have clear implications for the British currency: the Pound. The government will have to undertake a large programme of Gilt issuance- issuing new government bonds- and there is a finite level of demand for this paper. The amount of money the government needs to borrow is so large that they are going to have to offer higher interest rates in order get investors to buy Gilts. The problem is that with inflation already headed over 3%, the level of interest rates needed simply to ensure demand from investors will need to be at least 5%.

Which brings us back to the housing market. If we remember that the average Bank of England base rate- the benchmark interest rate in the British economy- since it was founded in 1694 is 5%, then the idea of talking about "affordability" when we see base rate at 0.5% and mortgage rates of only around 3-4% is very dangerous. The -incidentally unregulated- estate agency business has a clear interest in talking up prices. It has worked: housing prices have in real terms more than doubled and on some measures nearly quadrupled since 1975. The ratio between average salary and average house price is currently close to an all time high. Total indebtedness is also at an unsustainable level. All of this comes at a time when the interest rate cycle is set for a steep tightening.

On top of all of this is that, despite the fiscal stimulus, despite the dramatic fall in Sterling, from €1.40=£1.00 to €1.14=£1.00, the British economy is losing jobs. Glaxo is axing 4,000 jobs in the UK, Bosch nearly 1000 and there will be indeterminate job losses from the sale of Cadbury to Kraft. These are jobs in sectors that should have benefited from the fall of the Pound. All of these job losses come before the rise in rates that will be needed to be able to sell the amount of UK government debt that is coming onto the market over the course of 2010 and 2011. Higher rates and fewer jobs are not good for the fundamentals of the UK housing market.

So, at a fundamental level, it seems clear that there should be fall in house prices. My best guess is that about a 20% fall is justified by the fundamentals. However, the short term technical spike - lack of supply- could keep prices rising for a while. In addition Mr. Cameron now echoes Mr. Brown in saying that cuts in government expenditure will be more gentle than he had previously thought. To me that means unemployment may be lower, but that inflation will be higher. Usually that would mean interest rates rising, but the Bank of England has delayed its hike in rates.

I think that means that the policy makers are therefore relaxed about Sterling falling further. However I think it is a tightrope walk between trying to maintain economic stimulus and not letting inflation cause a meltdown in the currency and an emergency interest rate rise. I think the record of policy makers in avoiding these crises is very poor.

I therefore think there is going to need to be an emergency tightening -possibly even before the general election, particularly if the hung Parliament scenarios become common currency. The impact of a return to rates above 5% will show the current observers of the UK housing market to be living in a fools paradise. British Households did not pay down their debts while they had the chance- they inflated the housing market instead. The consequences will be dire.

So, as the punters adjust their views of the UK in the light of the January numbers. I do not: I still see a fundamental crisis in UK home ownership and a serious instability in Sterling. The effect on living standards, especially when combined with higher taxes to fund the bloated government sector is going to be bad. The only issue it seems to me is going to be the timing: and that I cannot judge just yet.